Money

[John K. Taber]

"Max Sawicky" <sawicky at bellatlantic.net> wrote:

<<<<<<<<<<<
Mat should recruit someone to do an online
LBO seminar, 'money for dummies,' or do it
himself.  I"ve said everything I know about
this, which isn't much.

mbs
>>>>>>>>>>>>

Several years ago, William Hummel posted a description of money
to the newsgroup sci.econ, which I thought was pretty good, but
I'm no expert. At the risk of confusing things even more, here
is his post.

--
John K. Taber

From: wfhummel at pacbell.net (William F. Hummel)
Newsgroups: sci.econ
Subject: An Essay on Understanding Money
Date: Fri, 06 Jun 1997 20:14:32 GMT

                                    UNDERSTANDING MONEY

I confess to a fascination with money -- acquiring it, to be sure, but
also in understanding what it is and how it works.  Money plays a
pivotal
role in the lives of individuals as well as in the economy as a whole.
Yet its complexities are such that no one can be totally free of
misconceptions about it.  Furthermore, the role and workings of money
are
constantly changing through innovation and evolution.  Concepts that are
true today could be obsolete tomorrow.  I wrote this essay as much to
help
crystallize my own thoughts as I did for publication.  It deals with
only
a few basic ideas.  But I think it can help others who also are
struggling
to gain a better insight.

The money I am talking about is fiat money, not commodity money.  The
distinction is important.  Commodity money is simply a certificate of
ownership of some valuable commodity like silver or gold.  It has an
intrinsic value because one can demand delivery of the commodity for the
certificate.  Fiat money is a creation of government that has no such
simple meaning.  The government can issue fiat money at trivial cost in
any amount.  That makes it far more difficult to understand.  Commodity
money is no longer in general use.  We should avoid being misled by
concepts that have lost their validity since the adoption of fiat money.

Definition of Money

Money has no simple definition, and there is disagreement as to what
instruments should included.  For this essay, I take the liberty of
defining money as any financial instrument that is widely accepted as
payment in a transaction on a same-day basis, plus the reserves of the
banking system.  This is more inclusive than the definition of M1 by the
Fed, which comprises only checkable deposits and currency held by the
public.  It includes two large pools:  money market mutual funds (in M2)
and consumer credit available through bank-issued credit devices.  Note
that it excludes what is often called "near money", debt securities with
short term maturities such as T-bills.  Such securities can often be
used
in direct transactions, but that usage is not widespread.  More often,
they must first be liquidated, i.e. converted into checkable deposits.
All fiat money is basically credit money, meaning that there is both a
creditor and a debtor associated with every dollar.  Even a dollar bill
is
formally a liability of the Federal Reserve Bank.

Money can be viewed as a stock or a flow.  As a stock, its main features
are how it is created, what controls its quantity, and how its value is
preserved.  Money as a stock is less complex and easier to understand
than
as a flow.  Not surprisingly, the concepts are less controversial.  As a
flow, the focus is on the dynamics of money and the interactions between
various sectors of the economy.  Any number of closed circuits can be
defined.  I will briefly discuss what I see as the three most important.
The first I call the fiscal circuit.  It comprises the reciprocal flow
of
funds between the government and the private sector.  There are two
other
important circuits, both of which are larger than the fiscal circuit.
What I call the industrial circuit  comprises the principal activity of
the private sector.  It includes the flow of household income into
consumption and savings, the investment in production that provides the
consumer product and the spendable income.  What I call the financial
circuit is an enormous flow of funds in financial instruments that is
largely independent of the real economy.

The Creation of Money

The story of money properly begins with the monetary base.  This is
money
the Fed  creates when it buys securities, mainly Treasury debt, from the
public for its own portfolio.  It pays for the bonds by creating a
deposit
at a Federal Reserve Bank for the seller’s own commercial bank.  The
transaction is the equivalent of what is sometimes described as
"printing
money".  That derogatory term, however, masks the fact that it is an
essential first step in the creation of the money supply.  The newly
acquired funds become reserves against which the bank can make
commercial
and consumer loans.  Each dollar of reserves can support a multiple in
loan dollars in our fractional reserve banking system.  In short, the
Fed
monetizes debt to provide the reserves that the banking system needs to
expand the money supply.  The process is ultimately limited by the
reserve
ratio requirements the Fed imposes on the all depository institutions.

Reserve Ratio Requirements

The reserve ratio requirement limits a bank’s lending power to some
fraction of its demand deposits. The current rule allows a bank to lend
90% of such deposits, leaving a reserve of 10% to cover possible
withdrawals by its depositors.  Since inflow and outflow are normally
random and tend to balance each other, this is usually a sufficient
margin. There is no required reserve for other bank liabilities, such as
savings accounts or certificates of deposit.  The rules, although set by
the Fed, are constrained within certain limits by the banking laws of
Congress.

The "money multiplier" in its basic form is simply the reciprocal of the
required reserve ratio. It is sometimes used to indicate how large the
credit money supply may become, given the total reserves of the banking
system.  As we will see, the money multiplier is little more than an
after-the-fact observation of the multiple.  The reason is that the
required reserve ratio actually has little to do with constraining the
size of the money supply.  The Fed does not directly target either the
money supply or the reserves that support it.  Instead its focus is on
the
price of money, which it controls through the leverage it gains from the
reserve ratio requirement.

Controlling the Price of Credit

Banks must show compliance with the reserve ratio requirement every
other
week or face penalties.  That creates an active money market in which
banks buy or sell reserves among themselves.  The interest rate on these
short term transactions is called the Fed funds rate.  A bank that is
short of reserves can, if necessary, borrow the funds it needs at the
Fed’s "discount window". The discount rate is normally set somewhat
below
its Fed funds target rate, and thus the discount window is an attractive
source for needed reserves.  However the Fed does not allow free use of
the discount window.  It expects banks to exhaust their other options
first.  The Fed steers the Fed funds rate to its target quite
effectively
through two market-influencing mechanisms - its control of discount
lending, and its "open market operations".  The latter involves short
term
transactions for its own account, adding or draining system reserves as
needed to balance the supply and demand at its target price.

Why does the Fed control the price of credit money rather than its
quantity?  The answer is that all past attempts to directly control the
money supply have resulted in unacceptably wide fluctuations in its
price.

Businesses cannot plan efficiently when the price of credit is subject
to
large and unpredictable changes.  As a result of the Fed’s focus on
price,
the money supply will vary with demand.  It expands or contracts
according
whatever factors influence private sector borrowing. The Fed must
provide
the reserves the banking system needs in its response to the borrowing
demand.  If it failed to do so, it would lose control of the Fed funds
rate, the bench mark for all short term rates.  The Fed plays a largely
passive role in this regard, doing only what is necessary in the short
term to hold the Fed funds rate on target.  As the credit money supply
increases, the Fed makes outright bond purchases in order to avoid ever
larger short term transactions.  Those are the bond purchases, mentioned
earlier, that increase the monetary base and the banking system
reserves.

Limiting the Money Supply

Since the reserve ratio requirement really doesn’t impede bank lending,
what prevents a bank from responding to any and all loan demands, and
what
limits the money supply from growing excessively?  The answer to the
first question is that each bank must also comply with an equity capital
requirement.  This is a complex formula that rates a bank’s assets by
quality and requires that its own capital exceed a certain fraction of
the
quality-weighted assets.  A bank can get into trouble by creating too
large an asset base through excessive lending.  A bank with too low an
equity/asset ratio will be placed under supervision by its regulator who
may demand to approve any new lending.  An insolvent bank can lose its
charter.

The answer to the second question -- what limits the money supply growth
-- is more complex.   If a creditworthy borrower is willing to pay the
bank’s rate, the bank will normally make the loan even if it must seek
the
funds after the fact.  This is almost standard procedure with large
banks.
The only defense against the creation of excessive credit money then is
for the Fed to increase the price of credit to the point that it slows
net
demand.  But this is like a small rudder on a massive ship.  It can take
a
long time before there is much response to the corrective action.  The
time lag in the credit market is usually a matter of many months.

Mismanagement of the credit money supply can readily drive the economy
off
track, towards inflation or recession.  The Fed must keep the supply of
credit money in reasonable balance with the production of real goods and
services -- its principal monetary policy task.  That calls for a great
deal of knowledge about the economy as well as skill in interpreting the
data.  The Fed has made its share of serious mistakes over the years,
mistakes that often were not obvious until much later.

The Fiscal Circuit

So far the discussion has focused mainly on money as a stock.  One of
the
easier flows to explain, yet often misunderstood, is the fiscal circuit.
This reciprocal flow of funds consists of government spending matched by
revenues from taxes and the sale of Treasury bonds.  The Treasury does
not
accumulate a surplus in its financial accounts as some state governments
do.  Rather it maintains just enough bank balances to cover its near
term transactions.  Thus the flow of funds back and forth with the
private
sector is essentially balanced at all times. This is true whether the
federal budget is balanced or not.  The size of this flow will expand
with
time as government spending increases, but no money is created in the
process.  That is done by the fractional reserve banking system,
augmented
by consumer lending through various bank credit systems.

The way the fiscal circuit relates to inflation is rather indirect.  It
does not involve an excess of money, but rather an increase in its
velocity.  As noted, any increase in funds spent by the government are
always returned through increased taxes and/or bond sales.  Those who
buy
the bonds tend to be net savers, while part of the government spending
flows to those who are likely to consume more than save.  On balance,
then, an increase in government spending will raise the effective demand
even though the money supply remains unchanged.  If at the same time
there
is an inadequate growth in the production of goods and services, the
effect would be inflationary.  However it usually takes an extended
period
of imbalance between supply and demand to cause a general increase in
prices.

There is a link between the government and the private sector via the
Fed
that deserves mention.  That has to do with the government bonds that
find
their way into the Fed’s portfolio.  The Fed receives interest from the
Treasury on those bonds, interest that once accrued to the private
sector.
When those bonds mature, the Treasury redeems them by paying to the Fed
their face value.  As a result, the Fed acquires a considerable income
each year from interest and redemptions.  A small portion of the Fed’s
income goes to pay for its operating expenses and for member bank
dividends.  The remainder (about 90%) is rebated to the Treasury.  It’s
interesting that this link effectively reduces the interest cost on the
debt by some small amount.

The Industrial Circuit

Consumer spending accounts for the major part of the GDP.  The spending
power arises out of household income that is itself the result of labor
and invested savings, which provides what is needed by the business
sector to produce the consumable product.  This very complex circuit is
the subject of endless analysis and debate in economics, and is not the
point of this discussion.  Rather the point is that growth in the
economy
depends upon an expansion of credit money.  It is not necessary to rely
soley on the investment of household savings.  Many businesses finance
their growth with borrowed money, i.e. newly created money that preceeds
the production. They do so with the expectation of servicing their loans
from profits earned on the new product, after which they can borrow
still
more.

In a nutshell, that is how the economy expands.  The money supply
increases right along with the growth.  If it did not, the growth would
be
throttled.  The new money created in borrowing is not inflationary under
normal conditions because of the additional product that is created.
However it can become inflationary if the borrowing costs are so low
that
consumers, who are also borrowers, are enticed into spending faster and
creating more demand than business expansion can support.

The Financial Circuit

The financial circuit, nearly insignificant 50 years ago, has grown to
be
the largest in terms of money flows.  It comprises flows between
financial
institutions in activities that are largely divorced from industry.  The
growth of these institutions is to a sizable extent dependent on lending
to one another.  A considerable amount of new credit money is thus
created
by the activities in this circuit.

A key feature is the multiple layering of financial assets whose values
are based on the capitalization of a future income stream that has no
counterpart in industry.  A good description of this circuit, referred
to
as fictitious capital flows by Robert Guttmann can be found in his book,
_How Credit Money Shapes the Economy_.

Some Lingering Questions

    1.  Aside from currency held by the public, can a significant amount
of money really sit idle in a way that serves no worthwhile economic
purpose?  If so how?

    2.  Considering the amount of money created for speculation in the
financial circuit, is the total money supply significantly larger than
it
needs to be for the real economy?

    3.  Since the money supply grows through the banking system’s
support
of the private sector economy, and the fiscal circuit does not itself
create money, what relation if any does the growth rate of the money
supply have to the budget deficit when government spending is
increasing?


Recommended Reading

_Financial Institutions and Markets_, by Meir Kohn, McGraw-Hill, 1994

_How Credit-Money Shapes the Economy_, by Robert Guttmann, Sharpe, 1994

_The Money Market_, 3rd edition, by Marcia Stigum, Irwin, 1989

_The Federal Reserve System, Purposes & Functions_, 8th edition, Board
of
Governerors of Fed, 1994

_Secrets of the Temple_ , by William Greider, Simon & Schuster, 1987

_The Bankers_, by Martin Mayer, Dutton, 1997

_Horizontalists and Verticalists_, by Basil Moore, Cambridge Univ Press,
1988

William F. Hummel
June 6, 1997